You’ve seen VIX. Now finally learn what it means.

I’ve come to two realizations about the CBOE Volatility Index, better known as VIX, in my time at S&P Dow Jones Indices.

First, this index, which is based on the prices of S&P 500 options, is known throughout the world. I have been fortunate to have lived in some interesting places – Hong Kong, London, and New York, to name a few. I can confirm firsthand that people who watch the stock market in these various places typically are aware of VIX. However – and this is the second lesson I have learned – very few people understand what VIX means. They loosely associate VIX with volatility, but if pressed, most could not tell you specifically what it measures.

This is understandable. Most market indices track the increases and decreases in value of a collection of securities. VIX, on the other hand, measures something less intuitive, namely the implied 30-day volatility of the S&P 500.

This phrase – “the implied 30-day volatility” – throws many investors and makes them tune out. But this shouldn’t be the case, because it’s not as complex as it seems. I will walk you through this phrase word by word to make it more approachable.

Implied – VIX is based on expectations, specifically the market’s expectations about how much the S&P 500 may move up or down in the future. These expectations are conveyed, or implied, in the prices of options.

30-day – VIX is not based on the market’s expectations for volatility any time in the future. Rather, VIX is focused on a specific point of time – 30 days ahead. So, if you are looking at a VIX level on September 15th, it is telling you information about the market’s expectations for the possible price level of the S&P 500 on October 15th.

Volatility – The VIX level signals the likely range of possible outcomes for the S&P 500, above and below the current level.

One important note to add. When we talk about the “market’s expectations,” the “likely range,” or “possible outcomes,” we are speaking in terms of probability, not certain results. I will break out the bell curves in futures posts, but it is enough now to understand that the market believes there is about a two-thirds chance that the S&P 500 level, 30 days from now, will fall in the expected range the VIX level implies.

Getting a feel for VIX

A great characteristic about VIX is that a given index level – say 15 or 11 or 23 – actually translates into meaningful information. I will explain this more at a different time, but for now, let’s work on getting an intuitive feel for what changes in the VIX level communicate. This can be done without the background mathematics.

In the chart below, the S&P 500 level is at 1697.6 on September 16th. The VIX level on this date is 14.42. This conveys that the market expects a range of possible outcomes 30 days from now somewhere between 1627 and 1768, a 141-point spread. (Again, ignore the math for now and simply focus on the directional changes in the charts that follow.)

Now let’s pretend that the VIX level on September 16th wasn’t 14.42, but was instead 7.00. The likely range of possible index levels for the S&P 500 would narrow to 1663 and 1732, as shown in the next chart. Now the expected range has gone down from 141 points to only 69.

Finally, let’s hypothetically increase VIX, taking it to 28.00. This would imply that the market is a lot less certain about the future and expects a range of possible S&P 500 index levels 30 days from now between 1560 and 1835, a huge range of 275 index points.

These charts illustrate the most basic principle every investor should understand about VIX. When VIX goes down, this reflects a narrowing in the expected range of possible outcomes for the S&P 500 thirty days from now. On the other hand, when VIX goes up, this expected range is getting wider.

Now that you have a good foundation, we’ll get down into some of the details in future posts.

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